MACROECONOMICS

“...we share a common commitment to a medium-term strategy: credible fiscal consolidation programs, successful anti-inflationary policies...”.

Anti-inflation policies - score: +1

Canada has been effective in meeting this commitment. Canada has had an explicit target range for CPI inflation since 1991. The targets was to reduce CPI inflation from over 5% in 1991 to between 1-3%. CPI inflation has been at or below 2% since and including 1992. In 1996, the annual average CPI inflation rate was 1.6% - in the lower end of the target range. Indeed, in the latter half of 1996, the Bank of Canada had become concerned of potential deflation. Inflation has now edged upwards and in the early months of 1997, the year over year CPI inflation rate was just over 2%. The outlook for annual average inflation in 1997 is 1.7%.

In the early 1990s, the weak inflation was the result of tight monetary conditions and the cyclical downturn in the economy. Apart from some strength in 1994, the economy has remained weak and the negative output gap large since 1990. The Bank of Canada has estimated that the output gap averaged about 3.5% in 1996 and remains around 2.5% in early 1997. This has exerted a strong downward pull on inflation. However, since early 1995, the Bank of Canada has moved to ease monetary condition significantly. Declining from over 5% in early 1996, by early 1997 the 3-month T-bill rate had fallen to 3% - a level not seen since the early 1960s and some 200 basis points below the US counterpart. Due to Canada's large trade exposure (exports and imports both account for about 40% of GDP) Canadian inflation is also vulnerable to movements in the currency. The significant decline in the Canadian dollar from the end of 1992 through to early 1995 contributed to easier monetary conditions.

Over the past year, the currency has generally oscillated in the 72-74 cents US range and now appears to have bottomed out, as have interest rates. The Bank of Canada has started to move monetary conditions into neutral because from late 1996, the economy has started to show clearer signs of strength. Real GDP is expected to rise 3-3.5% in both 1997 and 1998 up from 1.5% in 1996. Even so, the output gap is not expected to close until around 1999 and, with the unemployment rate still above 9%, it is unlikely that inflation will emerge as a threat over the short term.

Fiscal consolidation - score +1

Canada has been very effective in meeting this commitment. The federal government has reduced the federal deficit significantly and has improved the long term sustainability of the Unemployment Insurance Fund and the Canada Pension Plan.

---Stringent federal deficit reduction ---

The Liberal federal government initiated a program of severe expenditure cuts and modest tax increases in its 1995/96 fiscal year budget buttressed by explicit deficit targets. The program was confirmed (with minor modifications) in both the 1996/97 and 1997/98 budgets. The program of expenditure cuts has hit all areas, including administration, transfers to persons and business and transfers to the provincial levels of government.

The 1995/96 budget announced in February 1995, introduced a program with a three year cumulative deficit reduction of $29 billion relative to what the deficit would have been otherwise. Of this amount some $25 billion was to derive from expenditure cuts - the bulk of which to were derive from departmental expenditures. The budget sought to reduce the then projected 1997/98 deficit by $13.3 billion. The 1996/97 budget introduced a further $1.8 billion in expenditure cuts mostly targetted for 1998/99. The 197/98 budget and other pre-budget measures increased expenditures by under $1 billion for each year through to fiscal 1999/2000. The 1997/98 budget expenditure increases were probably prompted by the considerable deficit target underrun - and perhaps by the impending federal election.

As a result of this program, the federal deficit on a public accounts basis has been reduced from $37.4 billion (5% of GDP) in fiscal year 1994/95 to a preliminary estimate of $19 billion (2.3% of GDP) in fiscal year 1996/97. The latest 1997/98 budget released in February targets a $6 billion deficit in fiscal 1998/99. The preliminary deficit figure for 1996/97 came in considerably lower than targetted and the final deficit is likely to come in nearer to $13 billion - already lower than the $14 billion target for 1997/98. This was almost entirely due to the very cautious assumptions underlying the budget projections. It now appears that the deficit may well turn into a surplus as early as 1998/1999. The public accounts balance is expected to turn into a surplus at about the same time as the output expected to close. This suggests that the public accounts balance is currently close to a structural balance position.

On a national accounts basis (which includes the sizable Unemployment Insurance Fund surplus), the federal deficit has also shown considerable improvement. It has fallen from $35.1 billion in calendar 1993 to $26.6 billion in 1995 and down to $15.9 billion in 1996. A modest deficit is expected in 1997 and the balance may well turn into a surplus in the closing quarters of the year. This suggests that the national accounts balance is already in a structural surplus position.

What to do with the impending surpluses became a focal issue in the recent federal election campaign. This was won by the incumbent Liberal Party on June 2. The right of centre Reform and Progressive Conservative parties campaigned for debt reduction and tax cuts, while the left of centre New Democratic Party campaigned for renewed program expenditures. The moderately left of centre Liberal Party campaigned for continued deficit reduction until the public accounts deficit is eliminated. Subsequently, the Liberal platform called for a mixture of renewed program expenditures and tax cuts.

---Unemployment Insurance Reform---

A major overhaul of Unemployment Insurance (now called Employment Insurance) has now been in progress since 1995. The main thrust of the changes have been to reduce benefits. Contribution rates were also increased in 1996. This has contributed towards a significant fund surplus. Despite the weakness in the economy, the fund has now been in surplus since 1993 and in 1996 the surplus on a national accounts basis reached $6.5 billion (0.8% of GDP). This has contributed significantly to the bottom line of federal financing requirements. Indeed, the UI surplus will probably allow the federal financing requirements to turn negative in fiscal 1997/98. The unemployment insurance fund balance is included in the national accounts measure of the federal deficit, but not in the public accounts measure.

---Canada Pension Plan contribution rates increased---

The Canada Pension Plan is not part of the federal government balance sheet, but is administered jointly by the federal government and the provincial governments (with the exception of the separate Quebec Pension Plan). The plan moved into deficit in 1993 and there is serious concern about the long term viability of the plan. This is because the plan is organized on pay-as-you-go principles and the elderly dependency ratio is expected to increase significantly from the tail of the next decade. To address this issue, the federal and provincial governments agreed to raise the pension contribution rates. The pension contribution rate is to be increased from 5.6% of insurable income in 1996 to 9.9% in 2003, with most of the tax increase postponed until closer to 2003. The new measures imply that a plan surplus can now be expected by the turn of the decade.